Money Funds Conceal Risk Where Few Suspect

Mutual fund investors begin 1997 exposed to a $10 billion risk that many of them may not have thought about lately.

This hazard has nothing to do with the stock market, nor the chance that bonds might suffer a swoon the way they did in early 1996.

The danger in question arises in the realm of money market funds, where a record total of nearly $900 billion in assets reposed as of the latest tally by the Investment Company Institute.

Throughout 1996, yields on taxable money funds held pretty steady in the neighborhood of 5 percent. Municipal money funds returned about 3 percent to 3.4 percent, reflecting the income tax break they enjoy on interest payments.

After an extended spell of stability like that, it’s easy to start thinking of the returns on money funds as a given.

But, in fact, were a decline in short-term interest rates to push money funds downward toward the lows of about 3 percent they reached four years ago, their returns could quickly fall by a percentage point or more.

If you knock just 112 basis points, or 1.12 percentage points, off the yield on $900 billion in invested capital, you reduce the return by $10 billion.

Since it wouldn’t represent a loss of principal, it would never make news headlines, and many of the investors who are directly affected by it would most likely take it in stride. But the results would be every bit as real as a dip in stock or bond values.

And they would occur in a part of investors’ portfolios that most people view as a haven from risk.

Some observers now think rates are more likely to rise than fall, given robust trends in the economy such as a relatively low unemployment rate.

But in the eyes of one respected analyst, Charles Clough at Merrill Lynch, “if the economy weakens to the surprise of most investors, the most important financial market event of 1997 could be a sharp decline in short-term interest rates.”

In those circumstances, he adds, “much of the $400 billion (increase) socked away in money market funds and bank certificates of deposit over the past 21 months may be forced to migrate out on the yield curve.”

From a standpoint of market risk to one’s principal, further out on the yield curve is further out on a limb. Many people who switched from money funds to bond funds in 1993, when rates were falling, got clobbered in 1994 when rates turned upward and bond prices fell.

So what’s an investor to do now? That depends on what you expect from capital you have invested in money funds.

If you have the money there mainly for convenience and liquidity, and are willing to live with unexpected fluctuations in yield, you may comfortably keep it where it is.

But if you are counting on a steady return to cover essential living expenses or some other commitment, it might be wise to consider alternative possibilities where you can lock in a known dollar return for an extended period of time.